16

REGULATION OF ROBO-ADVISORY
SERVICES

Lee Reiners

A. INTRODUCTION 16.001 4.Examination 16.035

B. WHAT ARE ROBO-ADVISORS? 16.003 5.Responsibilities of robo-advisors
C. INDUSTRY OVERVIEW 16.006 registered as broker-dealers 16.036
D. BENEFITS OF ROBO-ADVISORS 16.009 6. Recommendations to change the
E. RISKS OF ROBO-ADVISORS 16.012 regulatory framework 16.042
F. REGULATION OF ROBO-ADVISORS IN G. REGULATION OF ROBO-ADVISORS IN
THE US 16.018 EUROPE16.043
1. Fiduciary duty for investment 1. MiFID 16.044
advisers16.019 2. National competent authorities 16.050
2. SEC guidance 16.027 H. CONCLUSION 16.054
3. Conflicts of interest 16.030

A. INTRODUCTION

The wealth management industry is massive and has historically been very 16.001
profitable. The Boston Consulting Group estimates that at the end of 2019,
the amount of assets under management by wealth management firms around
the world was approximately USD 89 trillion, with this figure expected
to reach USD 106 trillion by 2024.1 The industry has traditionally been
labour-intensive, with scores of advisers and retail brokers meeting with clients
face-to-face on a periodic basis to provide investment recommendations and
rebalance client portfolios. Given the industry’s size and previous lack of tech-
nological sophistication, it is no wonder tech start-ups have begun to put their
own spin on the very old business of managing other people’s money. These
new FinTech firms, commonly called robo-advisors, provide automated,

1 BCG, Global Asset Management 2020: Protect, Adapt, and Innovate, (19 May 2020), available at: Global
Asset Management 2020: Protect, Adapt, and Innovate (bcg.com).

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

algorithm-driven, financial planning services based on investors’ data and risk

preferences.

16.002 This chapter is structured as follows: Sections B–E explain what robo-advisors
are, provide an overview of the current industry landscape and describe key
benefits and risks of robo-advisors. Sections F and G analyse the regulatory
framework for robo-advisors in the US and Europe, respectively. Section H
concludes.

B. WHAT ARE ROBO-ADVISORS?

16.003 Robo-advisors combine insights from portfolio theory and behavioural eco-
nomics with modern technology. In the decades since John Bogle – founder of
Vanguard – wrote in his 1951 Princeton economics thesis that mutual funds
‘may make no claim to superiority over the market averages’,2 many economists
and investors have come to agree with Bogle that the average investor is better
served by buying and holding a low-cost and broad-based index fund than by
attempting to beat the market through actively buying and selling securities.
This simple premise has been upheld in numerous studies,3 including one by
Standard & Poor’s, who in their year-end 2017 report on the S&P 500, found
that ‘over the 15-year investment horizon, 92.33% of large-cap managers,
94.81% of mid-cap managers, and 95.73% of small-cap managers failed to
outperform’ their benchmark index.4 This insight has led to a mass exodus of
investors from actively managed funds to passively managed funds. In 1995,
passive funds accounted for 3 per cent of assets under management (AUM)
in mutual funds and exchange-traded funds (ETFs) in the US.5 This figure
rose to 14 per cent in 2005 and has accelerated dramatically ever since.6 As of

2 John C. Bogle, How the Index Fund Was Born, Wall Street Journal (3 September 2011), available at: https://​
www​.wsj​.com/​articles/​SB1​0001424053​1119045832​0457654468​1577401622.
3 See, e.g., Stephen Schaefer, Passive Beats Active Management, London Business School (10 April 2018),
available at: https://​www​.london​.edu/​faculty​-and​-research/​lbsr/​passive​-beats​-active​-management​-its​-not​
-scepticism​-its​-arithmetic; and Mark J. Perry, More Evidence that it’s very Hard to ‘Beat the Market’
over Time, 95% of Finance Professionals can’t do it, AEI (Mar. 202018), available at: http://​www​.aei​.org/​
publication/​more​-evidence​-that​-its​-very​-hard​-to​-beat​-the​-market​-over​-time​-95​-of​-financial​-professionals​
-cant​-do​-it.
4 Aye M. Soe and Ryan Poirier, SPIVA U.S. Scorecard, S&P Dow Jones Indices (2018), available at: https://​
us​.spindices​.com/​documents/​spiva/​spiva​-us​-year​-end​-2017​.pdf.
5 See Kenechukwu, et al., The Shift from Active to Passive Investing: Potential Risks to Financial Stability?,
Federal Reserve Bank of Boston Working Paper (2020).
6 Ibid., at 2.

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 C.  INDUSTRY OVERVIEW

March 2020, passive funds made up 41 per cent of combined US mutual funds
and ETF assets under management.7

Robo-advisors have capitalised on the rush to low-cost investing by utilising 16.004

ETFs that track broad market benchmarks, and by reducing, or eliminating,
human involvement in the portfolio selection process. The robo-advising
process starts by having consumers fill out an online questionnaire.8 The ques-
tionnaire elicits the consumer’s age, income, investing goals, risk tolerance,
investing timeframe and their current financial assets. Once this information
is collected, it is fed into the robo-advisor’s proprietary algorithm, which then
spits out a recommended asset allocation and one or more investment recom-
mendations. Clients with similar investment objectives and risk profiles gener-
ally receive the same investment advice and may hold the same or substantially
the same investments in their accounts.9

Not all robo-advisors are the same, and the level of service offered can vary 16.005
between firms. In their simplest form, robo-advisors will maintain a list of
products and portfolio allocations, and present the most suitable option to each
investor based on their answers to a questionnaire. It then falls upon the inves-
tor to implement the given allocation and periodically rebalance their portfolio.
More sophisticated robo-advisors will develop a comprehensive risk profile for
each client based upon their answers to a questionnaire and invest on behalf
of the investor in accordance with the recommended investment programme.
These robo-advisors may also automatically rebalance client portfolios to stay
within target allocations and engage in tax-loss harvesting in order to minimise
the client’s tax burden.

C. INDUSTRY OVERVIEW

The robo-advice industry was launched in the aftermath of the 2008 global 16.006
financial crisis, with the first robo-advisors, Betterment and Wealthfront,
founded in 2008 (they started offering their services to customers in 2010).
Both companies manage over USD 20 billion in client assets and are the
largest independent robo-advisors globally. With more than USD 680 billion

7 Ibid.
8 See, e.g., David John Marotta, Schwab Intelligent Portfolios: Built on a Faulty Premise, Forbes (22 March
2015), listing the questions on Schwab Intelligent Portfolio’s questionnaire; and Wealthfront, Assess
Your Risk Tolerance, available at: https://​www​.wealthfront​.com/​questionnaire, displaying page one of
Wealthfront’s initial questionnaire for prospective client.
9 See Melanie L. Fein, Robo-Advisors: A Closer Look (2015) (unpublished manuscript), available at: https://​
papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​2658701, at 2.

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

in AUM, the US is the clear industry leader.10 China is in the second place
with USD 74.5 billion in AUM at robo-advisors and Japan is in the third place
with USD 30 billion in AUM.

16.007 The robo-advising industry has grown steadily over the past ten years, with
total industry assets under management surpassing USD 827 billion in
2019.11 This number is expected to reach an eye-popping USD 16 trillion by
2025.12 This growth potential has attracted the attention of traditional money
managers who have begun to introduce their own robo-advice platforms that
are threatening the long-term viability of standalone robo-advisors. In 2015,
Charles Schwab and Vanguard respectively introduced Schwab Intelligent
Portfolios13 (SIP) and Personal Advisor Services.14 SIP utilises Schwab’s
own ETFs and cash allocation programmes insured by the Federal Deposit
Insurance Corporation (FDIC) to construct client portfolios, and charges no
advisory fees and commissions, or account services fees, to Schwab customers.
Vanguard’s Personal Advisor Services charges 0.30 per cent of assets15 under
management per year and combines ‘computerized asset allocation and rebal-
ancing with access to human advisors over the phone and via videoconferenc-
ing’.16 Other asset management, wealth management, and online brokerage
firms have followed Schwab and Vanguard’s lead and launched their own
robo-advice platforms, including: Fidelity, E-Trade, BlackRock and Credit
Suisse.17

16.008 Robo-advisors integrated with established financial institutions quickly

outgrew standalone robo-advisors like Betterment. Vanguard’s Personal
Advisor Services has over USD 160 billion in AUM and Schwab is the second

10 See Robo-Advisors – Worldwide, statista, available at: https://​www​.statista​.com/​outlook/​337/​100/​robo​

-advisors/​worldwide​#market​-users.
11 Ibid.
12 See The Expansion of Robo-Advisory in Wealth Management, Deloitte (2016), available at: https://​www2​
.deloitte​.com/​content/​dam/​Deloitte/​de/​Documents/​financial​-services/​Deloitte​-Robo​-safe​.pdf, at 1.
13 Charles Schwab, Charles Schwab Launches Schwab Intelligent Portfolios (9 March 2015), available at:
https://​pressroom​.aboutschwab​.com/​press​-release/​corporate​-and​-financial​-news/​charles​-schwab​-launches​
-schwab​-intelligent​-portfolios.
14 Janet Novack, Vanguard Rolls Out New Robo-Hybrid Advisor Service with $17 Billion in Assets, Forbes
(5 May 2015), available at: https://​www​.forbes​.com/​sites/​janetnovack/​2015/​05/​05/​vanguard​-rolls​-out​-new​
-robo​-hybrid​-advisor​-service​-with​-17​-billion​-in​-assets/​#450374b645c0.
15 Personal Adviser Services’ 0.30 per cent rate applies to investments below USD 5 million; above that, the rate
decreases as the value of assets invested increases. See Vanguard Advisers, Inc., Vanguard Personal Advisor
Services Brochure: Form ADV Part 2A (2018) at 4.
16 See Novack, supra note 14.
17 See, e.g., Robo-Advisor Upgrade! Installing a Program for Profitability: Digital Advice Raises Profits for
Investment Services Industry, Morningstar & Pitchbook (2018), available at: https://​www​.morningstar​
.com/​content/​dam/​marketing/​shared/​pdfs/​Research/​equityreserach/​Fin​ancialServ​icesObserv​erRoboAdvi​
sorUpgrade​.pdf​?cid​=​EMQ.

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 D.  BENEFITS OF ROBO-ADVISORS

largest robo-advisor, with USD 40.7 billion in AUM across its robo-advice
platforms.18 These integrated platforms were able to grow quickly because
they are operated by recognised and trusted brands, with large customer bases,
thereby allowing these firms to spend less on client acquisition. Large money
managers are also able to provide robo-advice at a lower cost than standalone
robo-advisors due to their ability to sell additional products and services
to their robo-advice clients. These competitive dynamics have led many
standalone robo-advisors to sell themselves to bigger companies, and those
that have not done so, have experienced a significant slowdown in growth.19
The challenges faced by standalone robo-advisors were crystallised when
Wealthfront’s ‘post-money valuation fell to USD 500 million after its January
2018 fundraising, compared with USD 700 million after its October 2014
fundraising’.20

D. BENEFITS OF ROBO-ADVISORS

Robo-advisors are growing in popularity for several reasons. For starters, 16.009
they are cheaper than traditional financial advisers who typically charge each
client an annual fee anywhere between 1 and 2 per cent of client assets under
management. In contrast, robo-advisors charge between 0 and 0.5 per cent in
management fees. Customers are also flocking to robo-advisors because they
offer the same, or higher, performance as traditional advisers and reduce the
emotional and cognitive biases that human advisers have.21 Why pay active
managers if they perform worse than the market? By utilising passive invest-
ment strategies selected by an algorithm, robo-advisors can beat active manag-
ers, providing higher returns to their customers at a lower price. Robo-advisors
are also an attractive option for those who wish to save for retirement or some
other future event but do not meet the minimum net worth requirements that
most traditional wealth management firms require. Most robo-advisors require
between USD 0 and USD 50,000 to open an account, whereas traditional
firms may require a minimum investment of at least USD 250,000.22

18 See Alex Eule, As Robo-Advisors Cross $200 Billion in Assets, Schwab Leads in Performance, Barron’s (3
February 2018), available at: https://​www​.barrons​.com/​articles/​as​-robo​-advisors​-cross​-200​-billion​-in​-assets​
-schwab​-leads​-in​-performance​-1517509393.
19 See, e.g., Robo-Advisor Upgrade!, supra note 17, at 12.
20 Ibid., at 7.
21 See, Megan Ji, Are Robots Good Fiduciaries? Regulating Robo-Advisors Under the Investment Advisers Act
of 1940, 117(6) Columbia Law Review (2017), at 1563.
22 US Gov’t Accountability Off., GAO-17-361, Financial Technology: Information on Subsectors and
Regulatory Oversight (2017), at 33 (hereinafter ‘GAO FinTech Report’).

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

16.010 By utilising algorithms, robo-advisors are also able to rebalance and tax-loss
harvest more efficiently than human advisers.23 Periodic rebalancing is required
to ensure that each investor’s portfolio stays within the original target alloca-
tions24 and is done by human investment advisers at predetermined time
intervals.25 Because robo-advisors utilise algorithms that continuously monitor
client portfolios, they can automatically rebalance a client’s portfolio the
moment asset allocations hit certain percentages (‘threshold-based rebalanc-
ing’).26 Automatic rebalancing ensures that ‘investment allocations continu-
ously reflect client-goals’.27

16.011 Tax-loss harvesting involves selling a security that has experienced a loss –
while simultaneously buying a similar security – so that the investor can incur
a capital loss that reduces their tax liability, while at the same time keeping
their portfolio at the desired allocation.28 Tax-loss harvesting requires deftly
avoiding the ‘wash sale rule’, which disallows a loss from selling a security if a
‘substantially identical’ security is purchased 30 days after or before the sale.29
Robo-advisors are ideally suited for compliance with the wash sale rule because
their algorithms can automatically identify and select ‘parallel securities’ that
are not ‘substantially identical’, but still allow the investors to maintain their
target asset allocation at all times.

E. RISKS OF ROBO-ADVISORS

16.012 As with any type of financial advice, whether it is provided by a robo-advisor

or traditional financial adviser, consumers face the risk of receiving unsuitable
investment advice. While a human adviser may be able to mitigate this risk by
probing consumers for more information to assess needs, risk tolerance or other
important factors, a robo-advisor’s ability to mitigate this risk may be based on
a discrete set of questions to develop a customer profile. Financial advisers of
all kinds can also make inaccurate or inappropriate economic assumptions,

23 Ji, supra note 21, at 1563.

24 See How and When Is My Portfolio Rebalanced?, Betterment, available at: https://​help​.betterment​.com/​hc/​
en​-us/​articles/​115004257146.
25 See Ji, supra note 21, at 1563.
26 See Michael Kitces, Finding the Optimal Rebalancing Frequency – Time Horizons vs Tolerance Bands,
Kitces.com: Nerd’s Eye View (4 May 2016), https://​www​.kitces​.com/​blog/​best​-opportunistic​-rebalancing​
-frequency​-time​-horizons​-vs​-tolerance​-band​-thresholds/​.
27 See Ji, supra note 21, at 1559.
28 See, e.g., White Paper: Tax Loss Harvesting+, Betterment, available at: https://​www​.betterment​.com/​
resources/​research/​tax​-loss​-harvesting​-white​-paper/​.
29 Ibid.; see also 26 U.S.C. § 1091 (2012) (codifying the wash sale rule).

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 E.  RISKS OF ROBO-ADVISORS

perhaps due to a failure to factor in changing economic conditions, which

could result in flawed investment recommendations. While human advisers
may be able to mitigate this risk to some degree based on their ability to adjust
to economic conditions, a robo-advisor’s ability to mitigate this risk is based
on whether its algorithm has been updated to reflect the most recent economic
conditions.

Until the COVID-19 pandemic, Robo-advisors had only been in existence 16.013
during a record bull-market run,30 and there were concerns around how
robo-advisors would perform during an inevitable market downturn. Anecdotal
evidence from past bouts of market turbulence suggested that robo-advisors
might struggle during a financial crisis or prolonged market downturn. In
the aftermath of the UK’s vote to leave the European Union in 2016 (Brexit),
popular robo-advisor Betterment halted trading for two-and-a-half hours
without notifying retail customers.31 Betterment responded to criticism by
noting that the firm does not trade into ‘highly unpredictable volatility’32
and that the firm’s ‘rights to suspend trading are spelled out in its client
agreement’.33 Betterment and Wealthfront experienced additional trouble in
February 2018 after the ‘Dow Jones Industrial Average shed more than 1,000
points and the VIX, a gauge of market anxiety, more than doubled in a matter
of hours’.34 Spooked by the market’s decline, customers tried to access their
accounts only to find they could not log in.35 Robo-advisors appear to have
cleaned up these issues judging by their performance during the market panic
of March 2020 that was caused by the onset of the COVID-19 pandemic.36
Both Betterment and Wealthfront remained online in early March 2020

30 The record was reached on 22 August 2018. See Gretchen Frazee, What the Longest Bull Market in History
Means for the Economy and Your Investments, PBS NewsHour (22 August 2018), available at: https://​
www​.pbs​.org/​newshour/​economy/​making​-sense/​what​-the​-longest​-bull​-market​-in​-history​-means​-for​-the​
-economy​-and​-your​-investments.
31 See Michael Wursthorn and Anne Tergesen, Robo Adviser Betterment Suspended Trading During ‘Brexit’
Market Turmoil, Wall Street Journal (24 June 2016), available at: https://​www​.wsj​.com/​articles/​robo​-adviser​
-betterment​-suspended​-trading​-during​-brexit​-market​-turmoil​-1466811073​?mod​=​article​_inline.
32 Ibid.
33 See Michael Wursthorn and Anne Tergesen, Robo Adviser Betterment Stokes Concern Over Brexit Trading
Halt, Wall Street Journal (2 July 2016), available at: https://​www​.wsj​.com/​articles/​robo​-adviser​-betterment​
-stokes​-concern​-over​-brexit​-trading​-halt​-1467403366.
34 Frank Chaparro, Betterment and Wealthfront Crash During Market Bloodbath, Business Insider (5 February
2018), available at: https://​nordic​.businessinsider​.com/​betterment​-and​-wealthfront​-crash​-during​-market​
-bloodbath​-2018​-2/​.
35 See Brandon Kochkodin et al., Fidelity Reports Web Issues After Robo-Adviser Sites Crash, Bloomberg (5
February 2018), available at: https://​www​.bloomberg​.com/​news/​articles/​2018​-02​-05/​robo​-adviser​-websites​
-crashed​-cutting​-clients​-off​-from​-accounts.
36 See Ryan Neal, Wealthfront and Betterment stayed online, while TD Ameritrade’s Essential Portfolios did
well by capturing more market upside than downside, Investment News (04 March 2020) available at: https://​
www​.investmentnews​.com/​robo​-adviser​-performance​-coronavirus​-selloff​-189460.

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

despite other online brokerage firms, most notably Robinhood, experiencing

prolonged outages.37

16.014 These disruptions highlight the fact that no amount of technological inno-
vation can overcome human psychology. When markets experience sharp
declines, investors behave irrationally and may not trust ‘the algorithm’ to
make decisions that affect their nest-egg. Without the ability to facilitate
face-to-face interaction, some robo-advisors may experience a mass exodus
of customers during the next severe market downturn.38 As Mary Erdoes, the
head of JP Morgan’s asset management unit said: ‘Human beings need human
beings to explain the world to them: that is our job.’39 Such sentiment is why
many robo-advisors, particularly those offered by traditional investment firms,
are incorporating a hybrid model where the customer has access to a human
adviser by phone or online chat.40 Even robo-advisor pioneer, Betterment,
now offers a service – ‘Betterment Plus’ – that provides customers with an
annual consultation with a financial adviser along with advice on portfolio
construction from a team of certified financial planners.41 Some robo-advisors
are even expanding their product offerings to further differentiate themselves
and attract new customers. This includes offering services like asset aggrega-
tion capabilities that enable the provision of ‘more holistic advice’ than fully
automated digital wealth managers, as well as checking and savings accounts.42
In fact, Wealthfront claims that the majority of new customers now come in
through their cash account product.43 Some robo-advisors have even capitalised

37 See Maggie Fitzgerald, Robinhood goes down again, causing clients to miss out on another historic trading
day, CNBC (09 March 2020), available at: https://​www​.cnbc​.com/​2020/​03/​09/​robinhood​-app​-down​-again​
-during​-another​-historic​-trading​-day​.html.
38 See, e.g., Samantha Sharf, Can Robo-Advisors Survive a Bear Market?, Forbes (28 January 2015), availa-
ble at: https://​www​.forbes​.com/​sites/​samanthasharf/​2015/​01/​28/​can​-robo​-advisors​-survive​-a​-bear​-market/​
#47a410b3e7ec; and Robert Litan and Hal Singer, Obama’s Big Idea for Small Savers: ‘Robo’ Financial
Advice, Wall Street Journal (21 July 2015), available at: https://​www​.wsj​.com/​articles/​obamas​-big​-idea​-for​
-small​-savers​-robo​-financial​-advice​-1437521976.
39 Ben McLannahan, JPMorgan Wealth Management Head Casts Doubt on Robo Advisers, The Financial Times
(28 February 2017), available at: https://​www​.ft​.com/​content/​2cfc2524​-fe0b​-11e6​-96f8​-3700c5664d30.
40 See, e.g., Clint Boulton, Roboadvisors Stand at the Vanguard of Human-Machine Collaboration, CIO
(25 March 2016), available at: http://​www​.cio​.com/​article/​3048318/​vertical​-industries/​roboadvisors​-stand​
-atthe​-vanguard​-of​-human​-machine​-collaboration​.html (describing Vanguard Group’s hybrid services); and
Bernice Napach, With FutureAdvisor, BlackRock Seeks to Compete with Schwab, Vanguard, Thinkadvisor
(14 June 2016), available at: https://​www​.thinkadvisor​.com/​2016/​06/​14/​with​-futureadvisor​-blackrock​-seeks​
-to​-compete​-with/​?slreturn​=​20190023162541.
41 See Ben McLannahan, Pioneer of Robo-advice Industry Opts for Human Touch, The Financial Times (31
January 2017), available at: https://​www​.ft​.com/​content/​c6b3bd9e​-e74f​-11e6​-893c​-082c54a7f539.
42 GAO FinTech Report, supra note 22, at 32–3. See also Bailey McCann, Robo Advisers Keep Adding on
Services, Wall Street Journal (08 March 2020), available at: https://​www​.wsj​.com/​articles/​robo​-advisers​-keep​
-adding​-on​-arms​-11583331556.
43 Ibid.

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 E.  RISKS OF ROBO-ADVISORS

on the growing interest in impact and environmental, social and governance

(ESG) investing. Launched in 2018, Newday Investing allows investors, with
a minimum of USD 100, to automatically allocate their funds into propriety
themed funds ‘that are tailored to the causes investors identify with most’,44
For instance, Newday offers portfolios titled Ocean Health, Climate Action
and Animal Welfare, to name a few.

As the use of robo-advisors grows more prominent, there are also justifiable 16.015
concerns around consumers being herded into identical, or similar, financial
products. This could result in ‘wide swaths of the population’ experiencing
highly correlated losses during a market downturn.45 To illustrate this point,
Professors Tom Baker and Benedict Dellaert provide the following analogy:

[c]onsider the impact of Google or Yelp on tourists’ search for a restaurant in a new town
as compared to the traditional approach of asking the hotel concierge for a restaurant
recommendation. Google … provides access to restaurant information to all tourists
in all towns, and it is easily accessible to everyone. If it gives systematically bad restau-
rant advice, the impact will be much greater than bad advice given by any individual
concierge … Of course, the consequences of providing poor restaurant advice even on
a large scale seem sufficiently small that regulating Google’s or Yelp’s restaurant reviews
seems unlikely to be necessary. However, the consequences of poor financial advice can
be severe even in an individual instance, and potentially catastrophic on a large scale.46

Investor herding also creates new cybersecurity risks. If a hacker caused 16.016
a robo-advice firm ‘to suddenly sell substantial assets, it could significantly
disrupt markets’.47

Robo-advisors rely on passive ETFs to construct client portfolios, which 16.017

means investors do not hold voting rights in the stocks that make up a given
ETF. Instead, the voting rights are held by the ETF provider, the largest being
BlackRock, Vanguard, and State Street. This means that these firms effectively
control an ever-growing share of the stock market, which has led to concerns
around declines in corporate governance and corporate accountability.48

44 See Newday Investing Brings Impact Investing to the Mainstream, PR Newswire (19 June 2018), available at:
https://​www​.prnewswire​.com/​news​-releases/​newday​-investing​-brings​-impact​-investing​-to​-the​-mainstream​
-300668363​.html.
45 See Benjamin P. Edwards, The Rise of Automated Investment Advice: Can Robo-Advisors Rescue the
Retail Market?, 93 Chi.-Kent L. Rev. 97 (2018), at 108.
46 Tom Baker and Benedict Dellaert, Regulating Robo Advice Across the Financial Services Industry, 103 Iowa
L. Rev. 713, 743 (2018), at 743.
47 Edwards, supra note 45, at 108.
48 See, e.g., John C. Bogle, Bogle Sounds a Warning on Index Funds, Wall Street Journal (29 November
2018), available at: https://​www​.wsj​.com/​articles/​bogle​-sounds​-a​-warning​-on​-index​-funds​-1543504551​
?mod​=​trending​_now​_4; Gita R. Rao, Give Mutual Fund Investors a Voice in Shareholder Proxy Voting,

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

F. REGULATION OF ROBO-ADVISORS IN THE US

16.018 In the US, the provision of investment advice is governed by the Investment
Advisers Act of 1940 (the Advisers Act).49 The Securities and Exchange
Commission (the SEC) is responsible for regulating investment advisers,
‘which generally includes firms that provide digital wealth management plat-
forms’.50 Therefore, most robo-advisors are subject to the same regulations as
traditional investment advisers and robo-advisors that manage over USD 110
million in assets are required to register with the SEC as investment advisers.51
The Advisers Act defines an investment adviser as any person who, for com-
pensation, engages in the business of advising others, either directly or indi-
rectly through publications or writings, as to the value of securities or as to the
advisability of investing in, purchasing, or selling securities.52 Under Section
203(b)(1), exemption from registration is available to investment advisers
whose clients are all within the same state as the adviser’s principal business
office and do not provide ‘advice or issue analyses or reports’ about securities
listed on any national securities exchange.53 However, all investment advisers
are still subject to the anti-fraud provisions in the Advisers Act’s Section 206.54
Generally, investment advisers with less than USD 110 million in assets under
management will be subject to the registration and oversight requirements of
the state securities regulator in the state where the adviser maintains its princi-
ple office and place of business.55

MarketWatch (12 December 2017), available at: https://​www​.marketwatch​.com/​story/​give​-mutual​-fund​

-investors​-a​-voice​-in​-shareholder​-proxy​-voting​-2017​-12​-12.
49 The Advisers Act defines an investment adviser as any person (i.e., individual or firm) who is in the busi-
ness of providing advice, or issuing reports or analyses, regarding securities, for compensation. 15 U.S.C.
§ 80b-2(a)(11); IA Rel. No. 1092.
50 GAO FinTech Report, supra note 22, at 36.
51 Some robo-advisors with less than USD 110 in AUM may still chose to register with the SEC, provided
they meet certain conditions. SEC Rule 203A-2(e) permits internet investment advisers to register with
SEC if the adviser provides investment advice to all of its clients exclusively through the adviser’s interactive
website, except that the investment adviser may provide investment advice to fewer than 15 clients through
other means during the preceding 12 months. See, Exemption for Certain Investment Advisers Operating
Through the Internet, Investment Advisers Act Release No. 2091 (12 December 2002), available at: http://​
www​.sec​.gov/​rules/​final/​finalarchive/​finalarchive2002​.shtml.
52 15 U.S.C. § 80b-2(a)(11).
53 203(b)(1) 15 U.S.C. §80b-3(b)(1).
54 Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Request for
Comment on Enhancing Investment Adviser Regulation, Investment Advisers Act Release No. IA-4889,
note 54 (18 April 2018), available at: https://​www​.sec​.gov/​rules/​proposed/​2018/​ia​-4889​.pdf (hereinafter:
‘Adviser Conduct Proposal’).
55 See Investor Bulletin, Transition of Mid-Sized Investment Advisers from Federal to State Registration, SEC
(2011), available at: https://​www​.sec​.gov/​files/​transition​-of​-mid​-sized​-investment​-advisers​.pdf.

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 F.  REGULATION OF ROBO-ADVISORS IN THE US

1. Fiduciary duty for investment advisers

The Advisers Act imposes a fiduciary duty on investment advisers and there 16.019
has been considerable debate as to whether robo-advisors are capable of
meeting this duty.56 A fiduciary duty was first read into the Advisers Act in
1963 when the Supreme Court decided SEC v. Capital Gains Research Bureau,
Inc. (‘Capital Gains’).57 Although the majority’s opinion did not explicitly state
that investment advisers have a fiduciary duty, the Court did interpret the
Advisers Act’s anti-fraud provisions in Section 206 to impose on investment
advisers an ‘affirmative duty of “utmost good faith and full and fair disclosure
of all material facts”’,58 and ‘to employ reasonable care to avoid misleading …
clients’.59

Subsequent Supreme Court decisions have interpreted Capital Gains as impos- 16.020
ing a fiduciary duty on investment advisers. For instance, in Santa Fe Industries,
Inc. v. Green, the court interpreted the Advisers Act to reflect the intent of the
Congress to ‘establish federal fiduciary standards for investment advisers’60
and in Transamerica Mortgage Advisors, Inc. v. Lewis, the court stated that the
‘Advisers Act establishes federal fiduciary standards to govern the conduct of
investment advisers’.61

Defining the exact substance of the Advisers Act’s fiduciary standard has fallen 16.021
to the SEC, who has issued numerous rules and regulations over the years to
provide greater clarity.62 The outcome of these actions is a clear understand-
ing that an adviser’s fiduciary duty encompasses a duty of care and a duty of
loyalty.63

According to the SEC: 16.022

56 Clifford E. Kirsch, Investment Adviser Regulation: A Step-by-Step Guide to Compliance and the Law
§ 8:8.5 n.180 (2018); and Nicole G. Iannarone, Computer as Confidant: Digital Investment Advice and
the Fiduciary Standard, 93 Chi.-Kent L. Rev. 141 (2018); David Quest QC, Robo-advice and Artificial
Intelligence: Legal Risks and Issues, Butterworths Journal of International Banking and Financial Law (January
2019).
57 SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (hereinafter Capital Gains).
58 Ibid., at 194 (quoting William I. Prosser, Handbook of the Law of Torts 535 (2d. ed. 1955)).
59 Ibid., (internal quotation marks omitted) (quoting 1 Fowler V. Harper and Fleming James, Jr., The Law of
Torts 541 (1956)).
60 Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 471, n.11 (1977).
61 Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979).
62 See, e.g., Investment Adviser Codes of Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004);
Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release
No. 2204 (Dec. 17, 2003) (‘Compliance Programs Release’); Electronic Filing by Investment Advisers;
Proposed Amendments to Form ADV, Investment Advisers Act Release No. 1862 (5 April 2000).
63 See Adviser Conduct Proposal, supra note 54.

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

the duty of care includes, among other things: (i) the duty to act and to provide advice
that is in the best interest of the client, (ii) the duty to seek best execution of a client’s
transactions where the adviser has the responsibility to select broker-dealers to execute
client trades, and (iii) the duty to provide advice and monitoring over the course of the
relationship.64

16.023 The duty of loyalty requires investment advisers to put their client’s interests
first.65 To meet the duty of loyalty, an adviser must ‘make full and fair disclo-
sure to its clients of all material facts relating to the advisory relationship’, ‘seek
to avoid conflicts of interest with its clients’, and ‘make full and fair disclosure
of all material conflicts of interest that could affect the advisory relationship’.66

16.024 Traditional investment advisers and some legal scholars have argued that
robo-advisors are not capable of meeting the Advisers Act’s fiduciary duty.67
Even the Massachusetts Securities Division has stated in a policy statement
that it believes that ‘fully automated robo-advisers, as currently structured, may
be inherently unable to carry out the fiduciary obligations of a state-registered
investment adviser’.68

16.025 When it comes to the duty of care, critics contend that an online questionnaire
does not gather enough information to allow for suitable investment recom-
mendations.69 Specifically, questionnaires may miss critical pieces of informa-
tion and do not capture information on assets outside a client’s account with
the robo-advisor. In addition, robo-advisors typically have no way of confirm-
ing if the information supplied by the client is correct. Finally, a client’s per-
sonal circumstances may change over time, thereby necessitating a reallocation
in their portfolio. Combined, these factors make it difficult for a robo-advisor
to act in the client’s best interest because they lack a comprehensive view of the
client’s financial circumstances and how it is evolving.

16.026 Some believe that only humans can meet the duty because face-to-face
conversation is required to pick-up on ‘the subtleties of a client’s situation’.70
Robo-advisor critics like to point to the disruption of service after Brexit and

64 Ibid., at 9.
65 Ibid., at 15.
66 Ibid., at 16.
67 See e.g., Fein, supra note 9.
68 Mass. Sec. Div., Policy Statement: Robo-Advisers and State Investment Adviser Registration 3, 5-6 (2016),
available at: http://​www​.sec​.state​.ma​.us/​sct/​sctpdf/​Policy​-Statement​-Robo​-Advisers​-and​-State​-Investment​
-Adviser​-Registration​.pdf [http://​perma​.cc/​Z9WR​-2HVS].
69 See Ji, supra note 21, at 1565.
70 Ibid., at 1567.

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 F.  REGULATION OF ROBO-ADVISORS IN THE US

the volatility in February 2018 as evidence that only humans can prevent inves-
tors from panicking and making investment mistakes.71

2. SEC guidance

Despite the limitations of online questionnaires in providing personalised 16.027

investment advice, the SEC has made it clear that robo-advisors are still
capable of meeting the fiduciary duty’s duty of care. Speaking at a conference
in 2016, then SEC Chairman, Mary Jo White, stated:

Just like a conversation with a ‘real person’ about a client’s financial goals, risk toler-
ances, and sophistication may be more or less robust, so too there is variation in the
content and flexibility of information gathered by robo-advisors before advice is given.72

Chairman White’s statement is an acknowledgment that human advisers face 16.028

many of the same challenges as robo-advisors in developing a complete picture
of a client’s financial situation. Just like robo-advisors, human advisers rely on
information provided to them by the client, and they may not meet with the
client frequently enough to incorporate changes in the client’s financial posi-
tion in a timely manner.

Recognising the ‘unique challenges and opportunities’ presented by 16.029

robo-advisors, the SEC issued staff guidance in 2017 to help robo-advisors
better understand how they can meet their legal obligations under the Advisers
Act.73 The guidance included suggestions for how robo-advisors can use ques-
tionnaires in such a way that only suitable investment advice can be provided.
The SEC encourages robo-advisors to consider:

● Whether the questions elicit sufficient information to allow the robo-advisor

to conclude that its initial recommendations and ongoing investment
advice are suitable and appropriate for that client based on his or her finan-
cial situation and investment objectives;
● Whether the questions in the questionnaire are sufficiently clear and/or
whether the questionnaire is designed to provide additional clarification or
examples to clients when necessary (e.g., through the use of design features,
such as tool-tips or pop-up boxes); and

71 Ibid.
72 Mary Jo White, Chair, SEC, Keynote Address at the SEC-Rock Center on Corporate Governance Silicon
Valley Initiative (31 March 2016), available at: https://​www​.sec​.gov/​news/​speech/​chair​-white​-silicon​-valley​
-initiative​-3​-31​-16​.html.
73 Div. of Inv. Mgmt., SEC, IM Guidance Update: Robo-Advisors 2 (2017).

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

● Whether steps have been taken to address inconsistent client responses,

such as incorporating into the questionnaire design features to alert a client
when his or her responses appear internally inconsistent and suggest that
the client may wish to reconsider such responses; or implementing systems
to automatically flag apparently inconsistent information provided by
a client for review or follow-up by the robo-advisor.74

3. Conflicts of interest

16.030 Robo-advisors and their supporters contend that the use of algorithms to
construct client portfolios reduces, or eliminates, the conflicts of interest and
biases that are prevalent in human advisors.75 However, these algorithms are
developed by humans; therefore, it is possible for biases and conflicts of inter-
ests to be embedded in computer code.76 These conflicts will take the form of
firm-client conflict, whereby the algorithm is programmed to do what is in the
best interest of the firm as opposed to what’s best for the client.77

16.031 Many robo-advisors have an affiliated broker-dealer that is owned by the same
parent company and that executes all the robo-advisor’s transactions on behalf
of clients.78 For instance, in their Form ADV submission – the uniform form
used by investment advisers to register with both the SEC and state securities
authorities – Betterment notes that:

Clients must establish a brokerage relationship with our affiliated broker-dealer,

Betterment Securities, a FINRA member broker-dealer. By entering into an Advisory
Agreement with Betterment, Clients authorize and direct Betterment to place all trades
in Clients’ accounts through Betterment Securities. As such, Betterment Securities will
maintain all client accounts and execute all securities transactions in client accounts
without separate commission costs or other fees. Betterment Securities exercises no
discretion in determining if and when trades are placed; it places trades only at the
direction of Betterment. Betterment Securities’ procedures are designed to make every
attempt to obtain the best execution possible, although there can be no assurance that
it can be obtained. Clients should understand that the appointment of Betterment
Securities as the sole broker for their accounts under this Wrap Fee Program may result

74 Ibid., at 7.
75 See, e.g., Megan Leonhardt, Capital One Launches Robo-Adviser, with Humans on the Phone, Time (17
June 2016) available at: http://​time​.com/​money/​4371434/​capital​-one​-launches​-digital​-advice/​: ‘The robots
like to say they have no conflict of interest because a computer dispassionately picks your investments.’
76 See FINRA, Report on Digital Investment Advice 9-10 (2016), available at: https://​www​.finra​.org/​sites/​
default/​files/​digital​-investment​-advice​-report​.pdf, at 13.
77 See Ji, supra note 21, at 1573.
78 Ibid., noting that this practice is common for all investment advisers, not just robo-advisors.

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 F.  REGULATION OF ROBO-ADVISORS IN THE US

in disadvantages to the client as a possible result of less favorable executions than may
be available through the use of a different broker-dealer.79

As Betterment makes clear, all client transactions are routed through their 16.032
affiliated broker-dealer regardless of whether it is in the client’s best interest.
As a result of this arrangement, client returns may suffer because Betterment
Securities has an incentive to quote less favourable prices – in the form of
bid-ask spreads – than a client could achieve elsewhere.80 While affiliated
broker-dealer arrangements are not illegal, and in fact are fairly common across
all types of investment advisers, the SEC acknowledges the use of affiliate
brokers presents a conflict of interest and therefore must be disclosed in Form
ADV Part 2, which is the narrative brochure written in plain English and
provided to clients.81

Another conflict of interest prevalent amongst robo-advisors run by tradi- 16.033

tional investment management firms is the use of propriety products in client
portfolios. For instance, Charles Schwab places their SIP clients in a portfolio
of ‘ETFs combined with the Schwab Intelligent Portfolios Sweep Program,
which automatically deposits, or “sweeps”, free credit balances to deposit
accounts at Charles Schwab Bank (Schwab Bank)’.82 Schwab acknowledges
that eligible ETFs include Schwab ETFs, which are managed by Charles
Schwab Investment Management, Inc.83 and that clients must pay the operat-
ing expense ratios of ETFs used in their portfolios, ‘including Schwab ETFs,
which affects the performance of SIP Program accounts’.84 The cash allocation
of SIP client portfolios is ‘swept’ to Schwab Bank, which earns revenue based
upon ‘the interest rate Schwab Bank pays to clients on such deposits and
the amount it can earn from the extension of loans and the purchasing of
investment securities with these deposits’.85 Although SIP clients can request
that certain ETFs be excluded from their account, Schwab is not required to
accommodate this request. Thus, even if SIP clients wanted to exclude Schwab
products and services from their account, they have little say in the matter.

79 Betterment, Betterment Wrap Fee Brochure: Form ADV Part 2A-Appendix 1, at 15 (2019), available at:
https://​s3​.amazonaws​.com/​betterment​-prod​-cdn/​agreements/​Betterment​_LLC​_ADV​_2019​_01​_03​.pdf.
80 See Ji, supra note 21, at 1574.
81 See SEC, Study on Investment Advisers and Broker-Dealers as Required by Section 913 of the Dodd-Frank
Wall Street Reform and Consumer Protection Act 27–28 (2011), available at: https://​www​.sec​.gov/​news/​
studies/​2011/​913studyfinal​.pdf, at 29.
82 Charles Schwab & Co., Inc., Schwab Intelligent Portfolios Disclosure, available at: https://​www​.schwab​
.com/​public/​file/​CMS​-BDL100049, at 4.
83 Ibid., at 5.
84 Ibid., at 8.
85 Ibid., at 7.

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

16.034 While the above conflicts of interest are not illegal, SEC regulation requires
they must be adequately disclosed to clients and potential clients. This disclo-
sure is crucial for a client’s ability ‘to make an informed decision about whether
to enter into, or continue, an investment advisory relationship’.86 While
a human adviser can deliver this information in writing as well as in-person
to the client, robo-advisors depend on ‘electronic disclosures made via email,
websites, mobile applications, and/or other electronic media’.87 In their 2017
guidance to robo-advisors, the SEC encourages robo-advisors to consider:
● whether key disclosures are presented prior to the sign-up process so
that information necessary to make an informed investment decision is
available to clients before they engage, and make any investment with, the
robo-advisor;
● whether key disclosures are specially emphasised (e.g., through design
features such as pop-up boxes);
● whether some disclosures should be accompanied by interactive text (e.g.,
through design features such as tooltips21) or other means to provide addi-
tional details to clients who are seeking more information (e.g., through a
‘Frequently Asked Questions’ section); and
● whether the presentation and formatting of disclosure made available on
a mobile platform have been appropriately adapted for that platform.88

4. Examination

16.035 Robo-advisors are examined just like traditional advisers. In its 2018 National
Exam Program Examination Priorities document, the SEC noted that it
will continue to examine investment advisers – including robo-advisors
– that offer investment advice through automated or digital platforms.89
These Examinations focused on registrants’ compliance programs, including
oversight of computer program algorithms that generate recommendations,
marketing materials, investor data protection, and disclosure of conflicts of
interest.90

86 SEC, IM Guidance Update, supra note 73, at 3.

87 Ibid., at 3.
88 Ibid., at 5 and 6.
89 SEC, 2018 National Exam Program Examination Priorities, available at: www​.sec​.gov/​about/​offices/​ocie/​
national​-examination​-program​-priorities​-2018​.pdf.
90 Ibid., at 5.

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 F.  REGULATION OF ROBO-ADVISORS IN THE US

5. Responsibilities of robo-advisors registered as broker-dealers

Robo-advisory firms can be investment advisers or broker-dealers, both of 16.036

which employ licensed professionals to assist investors with their financial
goals. Brokers are paid through commissions for the trades they make on
behalf of their clients and are governed by Financial Industry Regulatory
Authority (FINRA) rules. FINRA is a self-regulatory organisation that reg-
ulates member brokerage firms and exchange markets. Investment advisers
are paid either a straight fee for their time or a percentage of the assets under
management and as previously mentioned, are governed by SEC rules and
regulations. Many FINRA registered broker-dealers are also registered invest-
ment advisers.

Investment advisers are held to a higher legal standard than brokers. Whereas 16.037
investment advisers owe a fiduciary duty to their clients, brokers are held to
a suitability standard, which means that as long as an investment recommen-
dation meets a client’s defined need and objective, it is deemed appropriate.

In 2016, the US Department of Labor proposed the so-called ‘fiduciary rule’, 16.038
which would automatically elevate all financial professionals who work with
retirement plans or provide retirement planning advice – in accordance with
the Employee Retirement Income Security Act of 1974 (ERISA) – to the level
of a fiduciary.91 The rule would hold persons who provide investment advice or
recommendations to an employee benefit plan, plan fiduciary, plan participant
or beneficiary, IRA, or IRA owner as fiduciaries under ERISA. Due to the
broad scope of advice the fiduciary rule covers, it would effectively elevate all
brokers to the level of fiduciary.92

The fiduciary rule has been controversial from the beginning,93 and under- 16.039
went a lengthy legal challenge. The rule was effectively killed in March 2018
when the Fifth Circuit Court of Appeals vacated the rule after finding that
the Department of Labor exceeded its statutory authority under ERISA in
promulgating the rule.94

91 Definition of the Term ‘Fiduciary’; ‘Conflict of Interest Rule-Retirement Investment Advice.’ Federal
Register, The Federal Register (20 April 2015), www​.federalregister​.gov/​documents/​2015/​04/​20/​2015​
-08831/​definition​-of​-the​-term​-fiduciary​-conflict​-of​-interest​-rule​-retirement​-investment​-advice.
92 See Ron Carson, What the Demise of the DOL Fiduciary Rule Means For You: 4 Questions To Ask Your
Advisor Now, Forbes (5 August 2018), available at: https://​www​.forbes​.com/​sites/​rcarson/​2018/​08/​05/​
demise​-of​-the​-dol​-rule/​#5b26ae7f7318.
93 See, e.g., Iannarone, supra note 56, at 146–7.
94 Mark Schoeff Jr., Fifth Circuit Court of Appeals Vacates DOL Fiduciary Rule, Investment News (15 March
2018), available at: https://​www​.investmentnews​.com/​article/​20180315/​FREE/​180319947/​fifth​-circuit​
-court​-of​-appeals​-vacates​-dol​-fiduciary​-rule.

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

16.040 The death of the fiduciary rule does not mean broker-dealers are entirely ‘off
the hook’.95 In June 2019, the SEC finalised Regulation Best Interest,96 which
establishes a new ‘best interest’ standard of conduct for broker-dealers when
recommending a securities transaction or investment strategy to a retail cus-
tomer, including that the broker-dealer act without placing its own interests
ahead of the retail customer’s interests, and disclose and mitigate certain con-
flicts of interest. The new ‘best interest’ standard closes part of the gap between
the fiduciary standard that is currently applied to investment advisers and the
suitability standard that had previously applied to brokers.97

16.041 Similar to the SEC, FINRA recognised that many of the broker-dealers it
supervised were beginning to adopt digital investment advice tools, so in
2016, they issued a report reminding broker-dealers of their obligations under
FINRA rules and sharing effective practices related to digital investment advice,
including with respect to technology management, portfolio development and
conflicts of interest mitigation.98 The FINRA report on robo-advisors focused
on the governance and supervision of investment recommendations in two
areas: first, the algorithms that drive digital investment tools; and second, the
construction of client portfolios, including potential conflicts of interest that
may arise in those portfolios. FINRA recommends that robo-advisors should
be able to answer the following questions about their algorithms: (1) Are the
methodologies tested by independent third-parties? (2) Can the firm explain
to regulators how the tool works and how it complies with regulatory require-
ments? and (3) Is there exception reporting to identify situations where a tool’s
output deviates from what might be expected and, if so, what are the parame-
ters that trigger such reporting? FINRA also encourages robo-advisors to have
governance and supervision structures in place to review both the customer
profiles and pre-packaged portfolios that may be offered to clients.

95 The Labor Department plans to issue in September 2019 a revised final fiduciary rule package to replace the
one vacated this spring by the US Court of Appeals for the Fifth Circuit, according to Labor’s autumn regula-
tory agenda. See Melanie Waddell, New DOL Fiduciary Rule Coming Next Fall, ThinkAdvisor (18 October
2018), available at: https://​www​.thinkadvisor​.com/​2018/​10/​18/​new​-dol​-fiduciary​-rule​-coming​-next​-fall/​.
96 United States Securities and Exchange Commission, Regulation Best Interest: The Broker-Dealer Standard
of Conduct, Release No. 34-86031 (5 June 2019), available at: https://​www​.sec​.gov/​rules/​final/​2019/​34​
-86031​.pdf.
97 Note that the best-interest standard doesn’t go into effect until June 2020. Also, there is considerable debate
as to the level of consumer protection provided under the fiduciary standard compared to the best-interest
standard. This debate is partially fuelled by the fact that the new rule does not clearly define what ‘best inter-
est’ is. Nonetheless, it is generally agreed that the fiduciary standard does provide a greater level of consumer
protection. See Bob Pisani: A breakdown of whether investors are safer after the SEC passes financial protec-
tion rule, CNBC (6 June 2019), available at: https://​www​.cnbc​.com/​2019/​06/​06/​a​-breakdown​-of​-whether​
-investors​-are​-safer​-after​-the​-sec​-passes​-financial​-protection​-rule​.html.
98 FINRA Report on Digital Advice, supra note 76.

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 G.  REGULATION OF ROBO-ADVISORS IN EUROPE

6. Recommendations to change the regulatory framework

In July of 2018, the US Department of the Treasury released a report that 16.042
assessed non-bank financial institutions, financial technology and financial
innovation.99 Recognising the benefits that digital financial planning tools
provide to consumers, the report included several recommendations to help
simplify the existing regulatory framework for financial planning. Treasury
suggests that regulatory oversight for all financial planning services should
fall within one – new or existing – federal agency or a self-regulatory organi-
sation that would be subject to oversight by one or more federal regulators.100
Treasury believes that a simple and efficient regulatory structure would
provide greater legal certainty and avail more consumers – those with 401(k)
(defined-contribution pension) accounts in particular – to the benefits of
robo-advisors:

a number of digital financial planning tools do not provide advice on 401(k) accounts,
and some participants in outreach discussions indicated that regulatory compliance con-
cerns were a factor in such decisions. Given that 401(k) account balances may account
for a significant portion of an individual’s investment portfolio, the lack of advice on
such accounts will not advance Americans’ ability to save for retirement and accumulate
wealth.101

G. REGULATION OF ROBO-ADVISORS IN EUROPE

Similar to the US, the regulation of robo-advice in Europe is ‘technology 16.043

neutral’, meaning the same rules apply whether investment advice is provided
under a traditional model or an online platform.102 However, unlike the US,
capital markets in the EU are smaller and more fragmented.103 In addition,
European consumers are far less likely than American consumers to invest in
the stock market.104 To counteract these dynamics, the European Commission
(the Commission) launched a plan in 2015 for a single Capital Markets Union

99 US Department of the Treasury, A Financial System That Creates Economic Opportunities:

Nonbank Financial, FinTech, and Innovation, Report to President Donald J. Trump (2018), availa-
ble at: https://​home​.treasury​.gov/​sites/​default/​files/​2018​-07/​A​-Financial​-System​-that​-Creates​-Economic​
-Opportunities—Nonbank-Financi…pdf.
100 Ibid., at 164.
101 Ibid., at 163.
102 See Financial Stability Board, Financial Stability Implications from FinTech (2017), available at: http://​www​
.fsb​.org/​wp​-content/​uploads/​R270617​.pdf, at 27.
103 See Wolf-Georg Ringe and Christopher Ruof, A Regulatory Sandbox for Robo Advice, European Banking
Institute Working Paper Series 2018 – no. 26 (31 May 2018), at 12.
104 According to data from the OECD, US households on average hold 34 per cent of their financial assets in
shares and other equity, compared with 22.3 per cent for Italian households, 22 per cent for French house-

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

for all 28 member states.105 Considering that robo-advisor assets under man-
agement in Europe are just 5–6 per cent of what they are in the US,106 there
is potential for robo-advisory firms to expand access to financial services and
serve the policy goals of the Capital Markets Union.107

1. MiFID

16.044 In the EU, robo-advice has primarily been governed by the Markets in
Financial Instruments Directive (MiFID) which:

specifies the information that should be provided to clients, including in respect of the
financial institution; the services offered; the financial instrument(s); the risks involved;
as well as the overarching obligation that all information provided to clients and poten-
tial clients should be fair, clear and not misleading.108

16.045 MiFID 2, which came into force in January 2018, strengthened the require-
ments established in MiFID by requiring all investment firms to ensure that
investment advice is suitable for the client or potential client and forcing these
firms to disclose additional information to clients about the scope of advice
provided.109

16.046 To qualify as an investment firm under MiFID 2, the robo-advisory firm must
provide investment advice or portfolio management.110 MiFID 2 defines ‘invest-
ment advice’ as ‘the provision of personal recommendations to a client, either
upon its request or at the initiative of the investment firm, in respect of one or
more transactions relating to financial instruments’.111 Portfolio management
is defined as ‘managing portfolios in accordance with mandates given by clients
on a discretionary client-by-client basis where such portfolios include one or
more financial instruments’.112

holds, and 10.5 per cent for German households. See OECD, Household Financial Assets, available at:
https://​data​.oecd​.org/​hha/​household​-financial​-assets​.htm.
105 European Commission, Action Plan on Building a Capital Market Union, COM (2015) 0468, available at:
http://​eur​-lex​.europa​.eu/​legal​-content/​EN/​TXT/​?uri​=​CELEX​%3A52015DC0468.
106 See Orçun Kaya, Robo-advice – A True Innovation in Asset Management, Deutsche Bank Research (2017),
available at: https://​www​.dbresearch​.com/​PROD/​RPS​_EN​-PROD/​P​ROD0000000​000449125/​Robo​
-advice​_​%E2​%80​%93​_a​_true​_innovation​_in​_asset​_managemen​.pdf, at 1.
107 See, e.g., Maria Demertzis et al., Capital Markets Union and the Fintech Opportunity, 157 Journal of
Financial Regulation (2018), at 6.
108 ESMA et al., Report on Automation in Financial Advice, (2016), available at: https://​esas​-joint​-committee​
.europa ​ . eu/​ P ublications/​ R eports/​ E BA​ % 20BS​ % 202016 ​ % 20422 ​ % 20(JC ​ % 20SC ​ % 20CPFI ​ % 20Final​
%20Report​%20on​%20automated​%20advice​%20tools)​.pdf, at 11.
109 Ibid.
110 See Demertzis, et al., supra note 107, at 22.
111 Art (4)(1)(4) of MiFID 2.
112 Art (4)(1)(8) of MiFID 2.

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EU member states can exempt some robo-advisors who provide a limited 16.047
service from the investment firm requirements of MiFID 2. Exempt persons
are not allowed to hold client funds or client securities, nor are they allowed
to provide any investment service except the reception and transmission of
orders to investment firms authorised under MiFID 2.113 Thus, it is clear
that robo-advisors providing portfolio management do not qualify for the
exemption. Firms that qualify for an Article 3 exemption under MiFID 2 will
still be subject to stringent member state regulations pursuant to the MiFID 2
‘analogous’ requirement, which stipulates that member states’ conditions and
procedures for authorisation and supervision, as well as conduct of business
requirements, can be no less strict than what applies to investment firms under
MiFID 2.114

MiFID 2 requires the relevant authority of each member state to authorise 16.048
and register investment firms,115 and to subject investment firms to ongoing
supervision. Obtaining authorisation is a rigorous process that involves
meeting a number of requirements, including minimum capital require-
ments.116 Investment firms that provide investment services are required to act
in the best interest of their clients,117 and firms that provide investment advice
or portfolio management are required to gather sufficient information from
clients so that all recommendations are ‘suitable’ and in accordance with the
investor’s ‘risk tolerance and ability to bear losses’.118 In addition, investment
firms are required to take all appropriate steps to identify and to prevent, or
manage, all conflicts of interest.

Similar to robo-advisors operating in the US, European based robo-advisors 16.049

must take special care to ensure their investment recommendations are suitable
for the client and that conflicts of interest are clearly communicated. To help
clarify MiFID 2’s suitability requirements for robo-advisors, the European
Securities and Markets Authority (ESMA) released a consultation paper in
2017.119 ESMA’s guidance makes clear that the ‘use of electronic systems in
making personal recommendations or decisions to trade’ does not change the

113 Art (3)(1)(a–b) of MiFID 2.

114 Art (3)(2)(a–b) of MiFID 2.
115 Art 5 of MiFID 2.
116 See Demertzis, et al., supra note 107, at 23.
117 Art 24 of MiFID 2.
118 Art 25(2) of MiFID 2.
119 ESMA, Guidelines on Certain Aspects of the MiFID 2 Suitability Requirement, Consultation Paper (2017),
available at: https://​www​.esma​.europa​.eu/​sites/​default/​files/​library/​2017​-esma35​-43​-748​_​-​_cp​_on​_draft​
_guidelines​_on​_suitability​.pdf.

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

responsibility of firms.120 Specifically, ESMA notes that robo-advisory firms

‘should be aware that the ability of a client to make an informed decision
might be based solely on electronic disclosures made via email, websites,
mobile applications and/or other electronic media’.121 Given this, ESMA
encourages firms to present information in ‘a clear and simple way’ and explain
to customers the degree of human interaction available to clients. ESMA also
encourages robo-advisors to address any inconsistencies in client answers to
the online questionnaire and to provide the client with help when filling out
the questionnaire.122

2. National competent authorities

16.050 Despite the comprehensiveness of MiFID 2, robo-advisory firms still face

uncertainty as to how they are regulated. Firms ‘struggle with the distinc-
tion between investment advice and portfolio management and between
investment advice and investment intermediation’,123 the latter of which is
not covered under MiFID 2 and is therefore subject to domestic law. For
instance, in Germany, investment intermediation is not subject to a suitability
requirement.124 This regulatory uncertainty was highlighted in a 2017 mapping
exercise conducted by the European Banking Authority (EBA) whereby 282
FinTech firms were sampled to better understand how they are regulated pur-
suant to EU or national financial services legislation.125 For the robo-advisory
firms included in the sample, 35 per cent were under no regulatory regime, 41
per cent were regulated under EU law, and 24 per cent were regulated under
a national regime.126

16.051 To help provide greater regulatory clarity, some national competent authorities
(NCAs) have released additional guidance pertaining to automated advice
tools. For instance, in 2017, the German Federal Financial Supervisory
Authority (BaFin) released an article intended to help robo-advisors assess
whether they meet the definition of investment advice.127 The article notes

120 Ibid., at 7.
121 Ibid., at 13.
122 Ibid., at 14.
123 See, Demertzis, et al., supra note 107, at 24.
124 Ibid.
125 EBA, Discussion Paper on the EBA’s Approach to Financial Technology (FinTech) (2017), available
at: https://​eba​.europa​.eu/​documents/​10180/​1919160/​EBA+​Discussion+​Paper+​on+​Fintech+​%28EBA​-DP​
-2017​-02​%29​.pdf.
126 Ibid., at 26.
127 BaFin, Robo-advice – Automated Investment Advice in Supervisory Practice (2017), available at: https://​
www​. bafin​. de/​S haredDocs/​V eroeffentlichungen/​E N/​F achartikel/​2 017/​f a​_ bj​_ 1708​_ RoboAdvice​_ en​
.html;jsessionid​=​D9​E8AE0C452E​7CBD9986BE​859CA343B4​.1​_cid298.

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 G.  REGULATION OF ROBO-ADVISORS IN EUROPE

that robo-advice generally meets the definition of investment advice and

therefore requires authorisation under German banking or industrial law. In
March 2018, the Dutch Authority for the Financial Markets (AFM) released
a report clarifying the expectations it has regarding the further development
of automated financial services.128 The report notes that the Dutch Financial
Supervision Act makes no distinction between automated and physical service
provision. The AFM’s report also notes that robo-advisors are encountering
grey areas with respect to meeting their duty of care, ‘for instance in relation
to the client onboarding and the obligation to update client information’.129
Also in March 2018, the Luxembourg Commission de Surveillance du Secteur
Financier (CSSF) issued a communication on robo-advice which notes that
digital financial advice services in Luxembourg are subject to the same regu-
latory requirements as traditional financial advice services.130 Finally, in May
2016, the UK Financial Conduct Authority (FCA) set up an Advice Unit to
provide regulatory feedback ‘to firms developing automated models to deliver
lower cost advice and guidance to consumers’.131

The FCA also published guidance in 2017 for firms seeking to offer ‘“stream- 16.052
lined advice” on a limited range of consumer needs’.132 In addition, several
robo-advice firms have been admitted into the UK’s regulatory sandbox, which
– as described in more detail in Chapter 14 – is a safe space in which businesses
can test innovative products, services, business models and delivery mecha-
nisms without immediately incurring all the normal regulatory consequences
of engaging in these activities.133 For robo-advisory firms testing their product
within the sandbox, the FCA has required additional safeguards to ensure
consumers are receiving suitable advice.134 For some sandbox firms, this has
involved: qualified financial advisers checking the automated advice outputs
generated by the underlying algorithms, having an experienced adviser being
present when a consumer received automated advice, and notifying consumers

128 AFM, Guidance on the Duty of Care in (semi)automated Portfolio Management, (2018), available at:
https://​www​.afm​.nl/​en/​nieuws/​2018/​mrt/​doorontwikkeling​-roboadvies.
129 Ibid., at 3.
130 CSSF, Robo-advice, (2018), available at: http://​www​.cssf​.lu/​fileadmin/​files/​PSF/​Robo​_advice​_270318​.pdf.
131 https://​esas​-joint​-committee​.europa​.eu/​Publications/​Reports/​JC​%202018​%2029​%20​-​%20JC​%20Report​
%20on​%20automation​%20in​%20financial​%20advice​.pdf at 13.
132 See FCA, Streamlined Advice and Related Consolidated Guidance, Finalised Guidance (2017), available at:
https://​www​.fca​.org​.uk/​publication/​finalised​-guidance/​fg​-17​-08​.pdf.
133 The UK was the first country to implement a regulatory sandbox, but as of November 2020, 57 countries
operate a similar type of sandbox. See Sharmista Appaya and Mahjabeen Haji, Four Years and counting:
What we’ve learned from regulatory sandboxes, World Bank Blogs (18 November 2020) available at: https://​
blogs​.worldbank​.org/​psd/​four​-years​-and​-counting​-what​-weve​-learned​-regulatory​-sandboxes.
134 See FCA: Regulatory Sandbox Lessons Learned Report (2017), available at: https://​www​.fca​.org​.uk/​
publication/​research​-and​-data/​regulatory​-sandbox​-lessons​-learned​-report​.pdf, at 3.

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 Chapter 16 REGULATION OF ROBO-ADVISORY SERVICES

that they should not act upon the robo-advice until they have received a second
notification from a qualified financial adviser confirming that the advice is
suitable.135

16.053 All of the previously mentioned NCAs releases are intended to clarify how
robo-advisors fit with existing national regulatory frameworks. To date, no
NCA has issued new domestic legislation specifically covering automated
investment advice or portfolio management and the relevant European
Supervisory Authorities have determined that given a lack of material risk, no
immediate action is necessary to address robo-advisors at the EU level.136

H. CONCLUSION

16.054 While regulators in the US and Europe have thus far deemed existing laws
and regulations sufficiently flexible to cover the provision of automated invest-
ment advice and portfolio management, rapid technological developments
may soon force a rethink of the existing liability framework. Currently, the
legal entity that operates a robo-advisor is held liable for any breaches of laws
and regulations in the US or Europe. This liability framework is appropriate
given that the technology behind the robo-advisor was developed by the
firm – specifically employees working for the firm. But what happens when
investment recommendations and decisions cannot be explained by anyone
working for the firm? This scenario may sound far-fetched, but advances in
machine learning, deep learning, and artificial neural networks may soon allow
investment algorithms to scan massive amounts of data and make investment
decisions that are unexplainable to the simple human mind.137 Indeed, this is
already happening in other corners of the financial sector. In 2019, FinTech
startup Pagaya Investments announced it would be using big data and artificial
intelligence to trade, buy and sell the assets underpinning a consumer-loan
securitisation.138 Pagaya chief executive and co-founder Gal Krubiner said in
a company release that: ‘We’re just a few years away from all collateralized

135 Ibid., at 15.

136 ESMA et al., Joint Committee Report on the Results of the Monitoring Exercise on ‘Automation
in Financial Advice’ (2018), available at: https://​esas​-joint​-committee​.europa​.eu/​Publications/​Reports/​JC​
%202018​%2029​%20​-​%20JC​%20Report​%20on​%20automation​%20in​%20financial​%20advice​.pdf, at 4.
137 See, e.g., John Lightbourne, Algorithms and Fiduciaries: Existing and Proposed Regulatory Approaches to
Artificially Intelligent Financial Planners, 67 Duke L.J. 651–79 (2017); Quest QC, supra note 56.
138 See Glen Fest, Fintech Pagaya places $100M consumer loan ABS managed by AI, American Banker
(6 February 2019), available at: https://​asreport​.americanbanker​.com/​news/​fintech​-pagaya​-places​-100m​
-consumer​-loan​-abs​-managed​-by​-ai.

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 H.  CONCLUSION

loan obligations (CLOs), mortgage-backed securities (MBS), and ABSs being

managed by AI.’139 The wealth management industry cannot be far behind.

While no jurisdiction is currently considering revising existing liability regimes 16.055

for robo-advisors, some have begun to grapple with the unique challenges
artificial intelligence poses to existing legal frameworks.140 For instance, the
European Parliament has recommended the European Commission create
‘a specific legal status for robots’ and apply ‘electronic personality to cases where
robots make autonomous decisions or otherwise interact with third parties
independently’.141 As robo-advisors continue to develop and play a larger role
in the financial lives of ordinary consumers, expect more jurisdictions to revisit
the existing liability frameworks applicable to robo-advisors.

139 Ibid.
140 See, e.g., Steve Lohr, How Do You Govern Machines That Can Learn? Policymakers Are Trying to Figure
That Out, The New York Times (20 January 2019), available at: https://​www​.nytimes​.com/​2019/​01/​20/​
technology/​artificial​-intelligence​-policy​-world​.html.
141 Resolution on Civil Law Rules on Robotics, PARL. EUR. DOC. P8 TA(2017)0051, para. 59(f) (2017).

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